Dividends are an interesting thing.  Many closely held and private business owners do not think about dividends or dividend policy.  I have to admit that I’ve been thinking about private company dividends for a long time.  It all began with a call from a client way back in the 1980s.

I was regularly valuing a family business, Plumley Rubber Company, founded by Mr. Harold Plumley.  One day in the latter 1980s, Mr. Plumley called me and asked me to help him establish a formal dividend policy for his company, which was owned by himself and his four sons, all of whom worked in the business.  Normally I can’t divulge the names of clients, but my association with the Plumley family and Plumley Companies (its later name) was made public in 1996 when Michael Plumley, oldest son of the founder and then president, spoke at the 1996 International Business Valuation Conference of the American Society of Appraisers held in Memphis, Tennessee. He told the story of Plumley Companies and was kind enough to share a portion of my involvement with them over the then almost last 20 years.

Introduction

So that’s how I became interested in private company dividends and dividend policy.  The issue is still of great significance to owners of closely held and family businesses and deserves considered attention.

This is a two-part series on the topic of dividends.  We begin with an initial discussion of what dividends are, and then in the next post, we will talk about the “7  Critical Things to Know About Your Company’s Dividend Policy.”

Let’s put dividends into perspective, beginning with a discussion of (Net) Earnings and (Net) Cash Flow.  These are two very important concepts for any discussion about dividends and dividend policy for closely held and family businesses.  I’ll often drop the (Net) when discussion Earnings and Cash Flow, but you will see that this little word is important.

This initial discussion of Earnings and Cash Flow may seem overly simple for some readers, but please read on. We introduce some concepts that will be important as we talk about dividends and dividend policy in the next post.

(Net) Earnings of a Business

The Earnings of a business can be expressed by the simple equation:

Earnings = Total Revenues – Total Costs

Costs include all the operating costs of a business, including taxes.

• C Corporations.  If your corporation is a C corporation, it will pay taxes on its earnings and earnings will be net of taxes.  The line on the income statement I am referring to is that of net income, or the income remaining after all expenses, including taxes, both state and federal.
• S Corporations and LLCs.  If your corporation is an S corporation or an LLC (limited liability company), the company will make a distribution so that its owners can pay their pass-through taxes on the income.  To get to the equivalent point of net income on a C corporation’s balance sheet, it is necessary to go to the line on the income statement, also called net income (but it is not) and to subtract the amount total amount of distributions paid to owners for them to pay the state and federal income taxes they owe on the company’s earnings.  This amount would come from the cash flow statement or the statement of changes in retained earnings.

So, ignoring any differences in tax rates, the net income, after taxes (corporate or personal) should be about the same for C corporations and pass-through entities.

(Net) Cash Flow

Companies have non-cash charges like depreciation and amortization related to fixed assets and intangible assets.  They also have cash charges for things that don’t flow through the income statement.  Capital expenditures for plant and equipment, buildings, computers and other fixed assets are netted against depreciation and amortization, and the result is either positive or negative in a given year.  This lumpiness often occurs because capital expenditures tend to be “lumpy,” or occur in bunches, while the related depreciation expenses are amortized over a period of years.

There are other “expenses” and “income” of businesses which do not flow through the income statement. The investments, either positive or negative, relate to the working capital of a business.  Working capital assets include inventories and accounts receivable, and working capital liabilities include accounts payable and other short-term obligations.  Changes in working capital can lead to a range of outcomes for a business.  Consider these two extremes that could occur regarding cash in a given year:

• Make lots of money but have no cash.  Rapidly growing companies may find that while they may have positive Earnings, they have no cash left at the end of the year because they have had to finance their growth by leaving a portion of Earnings in the business in the form of working capital to finance investments in accounts receivable and/or inventories.
• Make little money, even have losses, and generate cash.  Companies that experience sales declines may earn little, or even lose money on the income statement, and still generate lots of cash because they collect prior receivables or convert previously accumulated inventories into cash during the slowdown.

Working capital on the balance sheet is the difference between current assets and current liabilities.  Many companies have short-term lines of credit with which they finance working capital investments.  The concept of working capital, then, usually includes changes in short-term debt.

In addition, companies generate cash by borrowing funds on a longer-term basis, for example, to finance lumpy capital expenditures. In the course of a year, a company may be a net borrower of long-term debt or be in a position of paying down its long-term debt.  So we’ll need to consider the net change in long-term debt if we want to understand what happens to cash in a business during a given year.

We are developing a concept of (net) Cash Flow, which can be defined as follows:

Earnings (Net of all Taxes)
+ Depreciation and any Amortization Expenses
– Capital Expenditures
+/-  Net Changes in Working Capital
+/-  Net Changes in Long-Term Debt
= Net Cash Flow (Cash Flow)

Most financial analysts and bankers will agree that this is a pretty good definition of Net Cash Flow.

Net Cash Flow is the Source of all Good Things

We focus on Cash Flow because it is the source of all good things that come from a business.  The current year’s Cash Flow for a business is, for example, the source of:

• Long-term debt repayment.  Paying debt is good.  Bankers are extremely focused on Cash Flow, because they only want to lend long-term funds to businesses that have the expectation of sufficient Cash Flow to repay the debt, including principal and interest, on the scheduled basis.  Companies borrow on a long-term basis to finance a number of things like land, buildings and equipment, software and hardware, and many other productive assets that may be difficult to finance currently.
• Reinvestment for future growth.  Investment in a business is good if adequate returns are available.  If a company generates positive Cash Flow in a given year, it is available to reinvest in the business to finance its future growth.  Reinvested earnings are a critical source of investment capital for closely held and private companies, and the investors in your company are you and your fellow owners.  Reinvesting with the expectation of future growth (in dividends and capital gains) is an important source of shareholder returns, but the return is deferred, at least in the form of cash, for a future date.
• Dividends or distributions.  Corporate dividends are also good, particularly if you are a recipient.  Cash Flow is also the source of dividends (for C corporation owners) or what we can call “economic distributions” (for S corporation and LLC owners).

So What is a Dividend?

At its simplest, a dividend (or economic distribution) reflects the portion of earnings that is not reinvested in a business in a given year, but paid out to owners in the form of current returns.

For some or many closely held and family businesses, effective dividends can include another component, and that is the amount of any discretionary expenses that likely would be “normalized” if they were to be sold.  Discretionary expenses include:

• Above-market compensation for owner-managers.  Owners of some private businesses who compensate themselves and/or family members at above-market rates should realize that the above-market portion of such compensation is an effective dividend.
• “Mystery employees” on the payroll.  Some companies place non-working spouses, children or other relatives on the payroll when no work is required of them.
• Expenses associated with non-operating assets used for owners’ personal benefit.  Non-operating assets can include company-owned vacation homes, aircraft not necessary for the operation of the business, vehicles operated by non-working family members, and others.

It is essential to analyze above-market compensation and other discretionary expenses from owners’ viewpoints to ascertain the real rate of return they are getting from their investments in private businesses.  In an earlier post, we talked about the rate of return on investment for a closely held business.  Assuming that there were no realized capital gains from a business, the return is measured as follows based on an earlier post:

(Dividends + Unrealized Appreciation) / Beginning Portfolio Balance

Now, we add to this any discretionary expenses that are above market or not normal operating expenses of the business that are taken out by owners:

(Dividends + Discretionary Benefits + Unrealized Appreciation /
Beginning Portfolio Balance

So now, we know what dividends are, and they include discretionary benefits that will likely be ceased and normalized into earnings in the event of a sale.

Wrapup

We won’t focus on discretionary benefits in the continuing discussion of dividends and dividend policy.  However, it is important for business owners to understand that, to the extent that discretionary benefits exist, they reflect portions of their returns on investments in their businesses.

As always, if you wish to talk with me about any business or valuation-related matters, or to discuss management or ownership transition issues in complete confidence, give me a call (901-685-2120) or email (mercerc@mercercapital.com).

Until next time,

Chris